What’s the deal with China’s Debt?

The world’s second-largest economy has been growing steadily at around 7% annually for the better part of this decade, leading many who believe in the Chinese economic miracle to favor China-focused funds and firms.

However, these sentiments were marred by reports from the International Monetary Fund (IMF) this summer, which cautioned that China’s recent economic growth has been fueled by an increasingly expensive debt load. The concern includes worries it could lead to a crisis in the future.

While there are various schools of thought on what this means, the fact that the country has taken on nearly $24 trillion of new debt since 2000 has alarmed many investors. S&P and Moody’s recent downgrades in Q3 2017 didn’t help matters either. Moody’s pointed to its expectation that Chinese debt will continue to rise rapidly in the coming years, leading to a gradual erosion of the country’s credit metrics.

Gross domestic product (GDP) growth also has decelerated in recent years from a peak of 10.6% in 2010 to 6.7% in 2016. The IMF conveyed that the new debt in recent years has been used inefficiently. Credit extended to industry, state-owned enterprises (SOEs) and many local governments has not been matched by a proportional rise in the value added by these borrowers. In 2015-16, it took 20 trillion renminbi of new credit to raise nominal GDP by just 5 trillion renminbi.

In addition, analysts estimate that two-thirds of corporate debt is in the hands of China’s sprawling state-owned enterprises (SOEs), most of which are unprofitable and inefficient. Apart from their lackluster 2.9% return on assets (source: Bloomberg), write offs due to bad loans made by the SOEs also have been increasing. Official Chinese sources document non-performing loans at the major banks at nearly 1.5 trillion yuan. However, some analysts believe bad debt figures are 10-14 times higher because of various methods used to obfuscate such data, as shown in the ThomsonReuters chart below.

Those who remain bullish on China point out that China’s debt-to-GDP isn’t as high as Japan & is about level with the United States and the European Union. Most Chinese debt is also locally funded by domestic deposits and denominated in Chinese yuan, making a 1998-style Asian financial crisis highly improbable in the near future.

(chart source ThomsonReuters)

The other major point China bulls raise is the makeup of the country’s debt. Only 40% of China’s debt is owed by households, compared with the US at nearly 80%. The majority of China’s debt is owed by corporations & State Owned Enterprises (SOEs) at around 165%.

Although this seems like a large number, it is dwarfed by the total assets of these corporations, which can be sold to repay debt if need be. The current corporate assets-to-GDP ratio is at ~550% according to Bloomberg, showing that while the debt load is large, it doesn’t seem untenable.

Furthermore, despite being loss-making and inefficient, SOEs are Chinese government-backed, meaning that their credit quality is guaranteed by the Chinese government (similar to Fannie Mae and Freddie Mac financial obligations backstopped by the U.S. government). China’s SEOs also generate profit, with their corporate earnings contributing to nearly 8% of GDP, according to the Chinese Finance Ministry.

Investing in China in 2018

China’s unique economic ascent over the last few decades has defied the “Western Capitalist” model many times. Traditional metrics have not been the best way to evaluate China’s mixed, communist/capitalist economy in the recent past. The broader stock markets seem to regard warnings raised about China’s debt by the IMF & China skeptics as overblown.

While the data coming out of China in 2017 should suggest a mixed outlook for the economy, the country’s stock markets have been unaffected by any such worries, outperforming the S&P 500 in 2017 so far. The graph below compares the year-to-date returns of the S&P 500 in orange, Hong Kong’s Hang Seng Index in red & mainland China’s version of the S&P 500, the CSI300, in blue.

Macro-economically, while China’s debt is problematic and should not be ignored, the country will be able to service it easily, as long as the economy grows around 6.5% annually. Additionally, Chinese Premier Xi Jinping who recently has been re-elected for another five-year term has promised to make reform of SOEs, as well as debt restructuring, key parts of his next term. Given some of President Trump’s rhetoric about China, however, trade friction with the United States will remain a risk to growth in 2018.

Those looking to invest in China in 2018 should remain conservative, given the recent run-up in the markets without a major correction. Despite the recent rise, the Shanghai & Hong Kong stock markets historically are undervalued with a current price-earnings (P/E) ratio of around 17 and 14, respectively, compared to a high of 25 for the U.S. market.

Investors should consider iShares FTSE/Xinhua China 25 Index (FXI), which tracks 50 diversified large-cap stocks listed on the Hong Kong exchange. The ETF is heavily weighted towards Financials (55% of holdings), which makes sense given Hong Kong’s position as a major financial hub. Despite its relatively high 0.74% management fee, the ETF has climbed over 32% so far in 2017, compared to the S&P 500 SPDR ETF’s (SPY) gain of 14.4%.

Karn Brij is a managing director at an international investment firm with interests in real estate, banking and alternative investments. He specializes in real estate, finance and India-focused investments.

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